Before you start trading with Forex, it’s important that you understand how the exchange rate works, and that it is determined by supply and demand.
How the price is formed
With Forex, you always trade in pairs. This is because you want to express the value of money in relation to something. The ratio between the two currency pairs is always noted as a ratio and a ratio number. With GBP/USD, you look at how many dollars you can buy with one pound.
If the price of GBP/USD is 1:1.20, then you get one pound for every 1.20 dollars. The first currency in the ratio is the basic currency and that is always one, the second currency is called the quote currency and this number indicates how much of the alternative currency you get in return.
How the price moves
With an upward price on the chart, the basic currency increases in value and the quote currency decreases in value. With a downward price, the basic currency decreases in value and the quote currency goes up in value. Keep in mind that the decrease of GBP/USD doesn’t mean that GBP/EUR also decreases; the opposite can certainly be the case!
Calculation based on pips
With the vast majority of currency pairs, a pip is the fourth number after the decimal point. When you read the price EUR/GBP 1.1234, the fourth number, 0.0004 is the current pip value. When the price goes up to 1.1235 the price moved by one pip and when the price goes up to 1.1244 the price has gone up by 10 pips.
The big exception to this rule is the Japanese Yen. The ratios involving the Japanese Yen have the pip set at the second number after the decimal point. With the price of EUR/JPY at 123.86, 0.06 is the pip value and an increase to 124 would mean an increase of 14 pips.
Long and short
Ultimately, you want to make money trading in Forex. You do this by guessing which way the price will go. With Forex, you can both buy (go long) and sell (short). When you go long, you make money when the price goes up and when you short, you make money when the price goes down.
With a broker, you usually have a buy (ask) and a sell (bid) price. Between these two prices there is a difference: the spread. The spread forms the transaction fees of the position that you open and is the broker’s source of income.
Test your knowledge!
- EUR/USD increases from 1.2176 to 1.2201, by how many pips does it increase?
- GBP/JPY decreases from 142 to 141.5, did you make money by going long or short?
- AUD/USD increases from 1.02677 to 1.02699, by how many pips does it increase?
- EUR/AUD offer 1.27364 late 1.27391, how many pips is the spread?
- If EUR/USD is 1.25, what is USD/EUR right now?